By Kevin Kelly, CFA, Jason Pagoulatos, Andrew Krohn, and Christian Cioce, Ph.D.
The Year Ahead for Markets is the final report of our Year Ahead series. It provides our top-down view of the biggest macro and market trends we’re focused on as we close the book on 2022 and look to the new year. We highly recommend reading all of the other sector Year Ahead reports to get a much deeper understanding of the most critical trends impacting individual sectors and the teams and protocols building the future of this industry.
2022 was The Great Reset for crypto. Overly hyped trends and mass speculation pushed the crypto market far out over its skis by the end of 2021, so this year’s washout was a necessary reset. Sizable corrections are healthy for long-term secular uptrends.
The last three years have been a tale of two halves.
The plot of act I was the culmination of policy responses to the post-COVID flash recession — massive stimulus programs were the stars of the show.
“The giant backstops put in place by such policies turned markets around almost on a dime, and were a key catalyst in propelling asset prices to new all-time highs. Financial conditions eased, risk appetite returned, and BTC and crypto assets were huge beneficiaries of this environment, which saw global liquidity expand at one of the fastest rates on record.”
Act II was the fall of the market’s shining white knight as our story’s hero turned into its biggest villain. All the tailwinds that propelled asset prices to new highs reversed course, and 2022 was the polar opposite of the previous 12 months — something we warned of a year ago:
“Several macro tailwinds that helped propel BTC and crypto assets to new highs over the last 12-18 months have reversed course; the shift away from excess liquidity and accommodative monetary conditions is a structural headwind we’ve highlighted in recent months, which now appears to be coming to a head.”
This leads us to an important theme we’ve been harping on since our earliest days — crypto is macro.
What’s happening in macro has a direct impact on the crypto market, as we’ve seen not just over the last two years, but arguably the better part of the last few price cycles. We’ll get into that shortly, but first let’s get a quick sense of the current state of the crypto market.
State of the Crypto Market
The sharp drawdown in crypto asset prices this year has many wondering when the pain will subside. General interest in many of the most prominent crypto themes of the last few years has died down considerably over the last 6-9 months.
Unsurprisingly, interest tends to pick up during bull markets and wane in bear markets.
BTC is trading right in the range of its previous 2017 peak and its summer 2019 retest, an area many consider to be a pocket of vulnerability as we head into 2023.
BTC is down ~76% from its prior all-time high. For context, the price of BTC fell ~85% from peak-to-trough in each of the last two major bear markets. History never repeats itself, but this year’s drawdown mirrors that of 2017-2018 in many ways.
ETH saw an even larger drawdown during the 2017-2018 cycle, falling 93% from peak-to-trough. ETH’s peak drawdown this year was 82% back in June — it’s currently trading ~76% off its prior ATH as well.
Interestingly, BTC and ETH peaked in November 2021, unlike the rest of the crypto market which peaked earlier in the year back in May 2021, as measured by the S&P Crypto BDM Ex-MegaCap Index. The broader crypto market has experienced an even sharper ~82% price drawdown from its all-time high.
If the market were to mimic the same peak-to-trough drawdown of last cycle (~93%), the total market cap for the broader market would have to fall another ~60% from here (though that’s not our base case).
Correlations between crypto and traditional asset classes have been very tight over the last 12 months, and for good reason. Intramarket correlations within crypto have also remained elevated this year, which has led to widespread weakness across every major sector.
Bitcoin is now trading roughly two standard deviations below its long-term trend.
Prior cycle bottoms were marked by a sizable selloff that pushed BTC into oversold territory on its 14-month RSI and a test of its 200-week MA, which historically served as strong support for price to find a floor. We saw these same conditions play out this past summer, and BTC has been largely rangebound since.
Past performance is not indicative of future results. But if this cycle follows the general path of those before it, one would expect to see markets consolidate into Q1 2023 before forming a clear bottoming pattern. This accumulation period in H1 2023 would be a welcoming setup for the crypto market to move into its next bull cycle. We would add that this is dependent on a reversal in the key macro headwinds that have weighed on risk assets throughout 2022.
Key Theme #1: Liquidity Still Runs the World
For those who haven’t read our “Liquidity Runs the World” report, we highly recommend it as a precursor for the topics discussed below.
We noted at the turn of last year that a sustained downtrend in global liquidity was the biggest risk to crypto markets heading into 2022.
“Bitcoin is one of the purest plays on fiat currency debasement. It also happens to be one of the most leveraged bets on global liquidity; when liquidity is abundant and expanding, BTC and crypto assets tend to outperform; when liquidity tightens, they struggle.”
Global liquidity is the most powerful force in macro, which is why it’s our first key theme and one which we believe will have a significant market impact in 2023.
Global liquidity cycles have a strong correlation with changes in the business cycle.
And the business cycle drives changes in asset prices.
Therefore, trends in global liquidity influence the direction of markets. They drive fluctuations in global equities…
And have a strong impact on the largest equity market in the world.
They even influence the direction of the crypto market.
And not just mega caps like BTC and ETH…
Global liquidity’s influence on crypto asset prices also affects capital flows into (and out of) crypto funds.
One caveat is that M2 is not an all-encompassing measure of global liquidity (see our prior report Liquidity Runs The World for a more in-depth discussion on these points), but it serves as a decent proxy. It tracks trends in major central bank balance sheets…
…and the relationship with markets, including crypto, is striking.
Liquidity cycles aren’t new — we’ve seen their power before. Global liquidity growth slowed considerably back in 2018 as financial conditions became more restrictive. The result was a sizable correction in risk assets and a prolonged bear market for the most speculative long-duration assets (like crypto). We saw a similar dynamic play out over the last 12 months, though on an even greater scale.
Global liquidity cycles drive changes in asset prices. They influence the direction of global equity markets. They drive fluctuations in bond yields and credit spreads. They even have a substantial impact on the crypto market, which is why a reversal in global liquidity is one of — if not the most — important catalysts for a renewed bull market.
It also looks like this liquidity cycle is approaching another inflection point.
Global Liquidity – The Reversal We Need
There are early signs that a reversal in global liquidity is upon us. Here’s an updated chart from CrossBorder Capital that shows the early signs of a potential bottom in this current cycle:
“The cycle moves in 5-6 year waves and is currently just starting to turn higher from its mid-2022 lows. Global liquidity leads financial markets by some 6-12 months and economies by around 12-18 months…it shows that we are at ‘maximum tightness’” – CrossBorder Capital
Our good friend Raoul Pal also has a great chart showing how the business cycle tends to lead liquidity reversals as well.
“…but the business cycle leads liquidity, and the ISM (shown inverted here) is forecasting significant economic weakness ahead, and thus liquidity is on the cusp of turning to offset falling growth…” – Raoul Pal, GMI
The two biggest contributors to global liquidity are the US and China. The world’s second largest economy has grown to be a liquidity powerhouse over the last 15 years.
Households in the US and China also make up nearly half of the world’s personal wealth.
After months of stern rhetoric, pressure is starting to mount on China as its economy sputters. Policymakers are warming up to the idea of supportive initiatives aimed at promoting growth as the country continues to grapple with significant headwinds (some of which are self-induced, e.g., zero-COVID).
The focus in China is shifting, and reopening its economy is now top of mind to combat its weakening growth outlook. The PBOC has already asked banks to “stabilize” lending to property developers, a critical sector for China’s economy, who’ve struggled to claw their way out of a year-long slump that’s left many companies cash-strapped and facing greater insolvency risk. The PBOC recently cut required reserves for banks for the second time this year — the latest of which is estimated to free up ~$70B of liquidity — and will likely take further action to prop up growth (especially as the rapid spread of COVID infections impact a growing percentage of its workforce).
China’s credit impulse has turned higher in recent months too.
Positive net changes in China’s credit impulse tend to lead to reversals in global M2 growth.
In recent years, they’ve also led trend reversals for the US dollar (which would be a very welcoming sign for markets).
Global liquidity cycles have an inverse relationship with the dollar, making them a key trend to monitor given our past warnings that a strong USD remains one of the biggest headwinds facing risk markets (including crypto).
We saw the year-over-year change in China’s credit impulse bottom ahead of the crypto market back in 2018, which may support a more optimistic outlook as we get deeper into next year.
The crypto market’s outperformance really started to accelerate after the net change in the China credit impulse turned positive, which is something we’ve already started to see over the last few months.
The Fabled “Fed Pivot”
The US is a bit of a different story, at least for now. Much to the dismay of investors, the Fed has aggressively targeted tighter financial conditions in its battle against inflation.
Tighter financial conditions are no friend of markets, especially risk assets whose valuations are grounded in potential growth further out in the future.
The US has yet to show signs of a liquidity reversal. Liquidity conditions have improved somewhat over the last several weeks, but more improvement is needed to see a sustainable move higher in markets.
The problem is that an expansion in global liquidity tends to loosen financial conditions, which is the opposite of what the Fed wants right now (at least until they have more confidence that persistently high inflation is officially behind them).
Many pundits are trying to predict when we’ll see a “Fed pivot,” but most are focused on when the Fed will pause rate hikes and if/when they’ll start signaling a new wave of rate cuts.
Rather, we’d argue that what really matters is when we see a reversal in liquidity conditions — that’s what will continue to have an outsized influence on markets and asset prices going forward. We saw this dynamic during the 2017-2018 cycle, which we highlighted at the start of the year:
“…the crypto market had one of its best bull runs on record [during 2017], even as the Fed (and other major central banks) started to raise rates…it wasn’t until liquidity conditions started to deteriorate that BTC topped out [as we saw in early 2018].”
TL;DR: We have to keep our eyes on changes in liquidity.
If the US and China move towards a more expansionary liquidity environment, that would give us stronger conviction that a bottom is truly in the rearview. Longer-duration risk assets will likely lead the way when the market realizes that the liquidity trend reversal has legs.
Liquidity Impacts Crypto Markets Too
This liquidity phenomenon isn’t just present in traditional markets, it’s also prevalent in crypto.
When prices are high, the crypto economy has a bigger balance sheet that can be borrowed against. During the 2020-2021 bull market, we saw the total amount of loans outstanding balloon alongside asset prices.
This year, we’ve seen a significant decline in demand for borrowing alongside the value of crypto assets.
This pullback in borrowing demand has led to a decline in utilization rates for the most prominent collateral types like USDC.
Centralized lenders have historically served as a notable source of liquidity. That’s why headlines about large prime brokers and lenders (like Genesis) needing emergency funding are so impactful. If we see further contraction in credit growth, that means less liquidity for the crypto economy.
Market makers also got caught up in the FTX collapse. Higher volatility forces MMs to reduce their risk, leading to worsening market liquidity conditions, as seen over the last several weeks. In the immediate aftermath of the FTX collapse, market liquidity for BTC-USD pairs dropped to its lowest level since early June, according to data from Kaiko.
The sizable drop in total stablecoin market cap after the LUNA/UST implosion is another example of a negative liquidity shock this year.
The transition to a risk-off environment has pushed many market participants to stack stables, which has drastically increased their percentage of the total market cap. This represents capital that hasn’t left the crypto economy. Once the market turns, we’d expect to see some of this dry powder re-enter the market.
Capital flows have a big impact on asset prices throughout global markets and economies. As we’ve seen, the decline in funding liquidity can have an adverse impact on market liquidity too.
Access to liquidity is one of the biggest risks to the crypto industry over the next 3-6 months. Venture capital funding has fallen considerably year-over-year, which is forcing companies big and small to cut costs and headcounts in an effort to ensure their survival. The back half of the year has been challenging for many teams looking to raise capital for new projects or series funding for existing ventures, and conditions will likely get worse before they get better.
Key Theme #2: The Almighty US Dollar
The strong dollar narrative has been a cornerstone theme of ours throughout 2022. In our January report, Why Bitcoin Is Behaving Like It Should, we cited the likelihood of a strong dollar as a key risk to the crypto market. More specifically, we cautioned that:
Growing expectations for higher rates, coupled with a relatively strong economic outlook in the US — at least compared to other regions — have helped breathe new life into the US dollar
A stronger greenback implies tighter monetary conditions, which does little favor to assets like BTC that tend to move inversely with the USD
The US dollar is extremely important in determining the direction of global markets, especially assets tethered to a currency debasement narrative
Fast forward a year and we’ve seen the USD strengthen against just about every major currency to the detriment of risk assets like crypto. The 15 months leading up to its late-September peak saw the strongest dollar move we’d seen in decades, so we expected some consolidation after such a rapid rise.
Aggressive monetary tightening, demand for dollars and US safe havens, and the contraction in global liquidity helped propel the dollar to 20-year highs.
Historically, dollar momentum can continue after a healthy consolidation period.
We saw the DXY’s 14-month RSI break above 70 at the end of April for the first time since its 2014-2016 run-up. Shortly after, we cited the importance of USD momentum, specifically how “Similar overbought readings over the last four decades led to a stronger dollar ~78% of the time over the following 12 months [with average gains of ~5.7%]…which would put the DXY index just shy of 111…”
The DXY went on to gain another +10% through late September (peaking at 114), but has since fallen back to the same levels we saw in May.
The worldwide fight against surging inflation has prompted a synchronized tightening of global rates and financial conditions, and the strong dollar continues to be a big part of that story.
October marked the recent turning point, as peak “tightness” led to somewhat easier financial conditions and the market started repricing future rate hikes as fears shifted from inflation to rising recession risk.
The US led the pack in tightening financial conditions over the last 12 months, but that’s starting to change as inflation and energy pressures inflict hardship on Europe while the Fed gets closer to its expected terminal rate.
The destructive strength of the US dollar has also forced other countries (both advanced and developing) to take action, defending their own currencies in the face of major economic headwinds. Foreign CBs have started selling dollar reserves at an accelerated pace, similar to what we saw after the last strong USD run-up (2015-2017).
This trend has been led by China and, more recently, Japan (more on this later).
Long dollar is also one of the most overcrowded trades at the moment.
We know global liquidity cycles have an inverse relationship with the dollar. We also noted how the business cycle tends to lead changes in liquidity trends, and the US ISM has been warning of a significant slowdown for months now.
Therefore, if we expect the liquidity cycle to turn (as we’re already seeing early evidence of) to combat this weakening growth outlook, then we’d expect to see a reversal in the USD too.
So, are we out of the woods? Not necessarily. Another wave of dollar strength is still a key risk as we move into 2023. It is important to acknowledge that the Fed remains steadfast in their fight against inflation, and we know through historical precedent that the latter stages of inflation can be sticky, especially if wage growth remains strong.
The dollar’s run-up has already caused a lot of destruction, but the US still looks like the “cleanest shirt in the laundry” to many. If capital flows to the US in search of safety against weakening growth prospects elsewhere — like the eurozone — we could see another dollar rally. Demand for dollars remains high, and dollar liquidity constraints only add more fuel to the fire.
If we get another period of dollar strength, it’d likely mark the end of the latest relief rally. The size and speed of USD fluctuations is critical too. If the USD appreciates too much too fast, the potential for major currency depreciation and debt issues becomes increasingly high — with cracks already emerging in both. Dollar-denominated debt outside the US has grown considerably over the last 15 years, and another leg higher would tighten global financial conditions even further.
Periods of extreme stress often lead to unforeseen breakdowns in financial markets, something crypto participants know all too well at this point.
A couple of interesting examples where this stress could manifest are the Hong Kong dollar peg (HKD, above left) and the Japanese yen/JGB market (above right). The above charts are prominent examples of potential cracks in global currency and sovereign debt markets, and ones that could be strained if we see another period of consistent USD strength. The debacle in the UK gilt market is another example that’s lingering in the minds of US officials.
It’s important to note that betting on an HKD depeg has been an infamous “widowmaker” trade over the last 15 years. Also, as this was going to print, the BOJ announced an increase in the yield cap on 10yr JGBs. This sparked a jump in the yen and a new wave of hawkish concerns, as many believe this opens the door for a tighter monetary regime after Japan’s seemingly steadfast dovish stance.
Once again, global liquidity trends have a lot of influence on where we go from here. The fragility of sovereign bond markets may inhibit the Fed’s QT plans, bringing with it a weaker dollar and some much needed relief to markets that have lost their luster this year. If policymakers can avoid an outcome in which the dollar remains a strong, consistent threat, then risk assets stand to benefit considerably.
Key Theme #3: The Narrative Shift From Inflation Risk → Recession Risk
Our third key theme for 2023 is the narrative shift from inflationary risks to recession risks. The Fed remains focused on its top priority to curb inflation, and Fed Chair Powell has stated numerous times that a period of sustained, below-trend growth is likely necessary in order to achieve this end.
Obviously, the Fed isn’t in the business of destroying wealth and forcing recessions. While there’s much debate over their effectiveness, Jay Powell & Co. aren’t sitting behind closed doors scheming up ways to inflict as much pain as possible. They’re implementing the policies that they believe have the best chance of combating the highest inflationary pressures seen in decades. Unfortunately, the best antidote for stubbornly high inflation is a recession, and the Fed knows that.
In recent weeks, there have been signs that peak inflation may be behind us, leading to a less aggressive 50bps hike at the December FOMC meeting. However, we believe the Fed will aim to keep financial conditions tight for a prolonged period in order to avoid the perceived mistakes of the 1970s, even if it means an increased risk of recession. The transition from inflation concerns to recession risks is a narrative we believe will dominate the headlines throughout 2023.
Policy Paths Forward
It appears the market is preparing for its next boss to fight.
Leading indicators continue pointing to an economic slowdown.
The rapid decline in global liquidity growth and the aggressive tightening of financial conditions this year led to one of the largest wipeouts of net worth we’ve ever seen. The degree of such a negative wealth effect can also hinder personal consumption, but it may not be as effective given the high concentration of wealth in the US (where the top 20% of earners own ~70% of household wealth).
Consumer spending is holding up better than many expected, but inflation continues to eat into purchasing power and real wage growth.
Buying conditions for large expenditures (houses, vehicles, household durable goods) are still near the worst levels we’ve seen in decades.
We’ve also seen the fastest decline in homebuying conditions and housing affordability as average rates on a 30-year mortgage still top 6.5%.
As a result, consumer sentiment has taken a big hit this year. Historically, lower sentiment readings of a similar magnitude have preceded material increases in unemployment (UE rate is lagged 18 months in the below chart).
Forward-looking indicators also imply a less optimistic outlook for the labor market, especially if we’re knocking on recession’s door.
The latest FOMC forecasts show that more Fed members see upside risks to unemployment, but the reported unemployment rate is still hovering near record lows.
Typically, we see the unemployment rate start to tick up and cross over its 12-month moving average heading into recessions. The current 12-month moving average is right in line with the latest unemployment rate print, but the Fed’s latest forecast shows unemployment rising to 4.6% next year, which would put us on a similar track to prior recession examples.
Financial conditions have tightened at a record pace, which typically doesn’t bode well for future unemployment either (UE rate is lagged 9 months in the below chart).
The Fed has cited the resilience in nonfarm payrolls and wage growth as key pressure points that may keep inflation elevated. However, alternative data and dissections of the US labor market are telling a different story.
“A good gauge for the current state of the US labor market is the pace of full-time hirings (excluding multiple jobholders). On a rolling 6-month % change basis, the momentum in US full-time hiring is basically flat and in line with the weakest prints (ex-pandemic) of the last 10 years.” – The Macro Compass
Alf Peccatiello, founder of The Macro Compass, also shows how rapid changes in US financial conditions tend to “lead job creation trends by 9 months.”
The question now is whether policymakers will wait for unemployment to signal a weakening labor market in order to justify a transition away from tighter policy, or if they’ll lean on forward-looking indicators to get ahead of what’s expected to come. Rising recession risks mean peak labor market tightness may be in the rearview, as wage growth tends to fall alongside rising unemployment (both of which are lagging indicators).
The Fed’s credibility rests on its ability to rein in inflation, no matter the cost. Several forward-looking indicators imply economic weakness ahead, setting up 2023 as a year where recession worries take center stage.
Until Something Breaks
If we avoid a serious recession and policymakers somehow manage to engineer a “soft landing,” it’s less likely the Fed will make any drastic pivot — that is unless something breaks and their hand is forced.
Liquidity conditions have been deteriorating in the world’s most important securities market (US Treasuries), the proper functioning of which is critical for the entire global financial system. We’ve been talking about the growing fragility of the US Treasury market for months, and it’s a situation we continue to monitor closely.
Historically, these types of conditions tend to be a bullish setup for bonds. But so far, Treasury yields have deviated from their historical trend, even as the business cycle continues to show signs of weakening.
US Treasuries are the world’s risk-free asset. They’re the pillar of global FX reserves, they underpin global risk portfolios, and they’re one of the most prominent forms of accepted collateral. There is no comparable alternative, which is why an illiquid Treasury market is a real systemic risk. If the market loses faith in the ability to accurately price — and importantly sell — the global risk-free asset, the whole system starts to break down.
Bond losses also reduce the value of pledged collateral, which increases margin calls and reduces leverage in the financial system. This can have adverse consequences for market liquidity and can further dampen growth when credit becomes more scarce.
“The tide of the last bull market is rapidly going out and leaving many leveraged investors dangerously exposed. The irony is that, on this occasion, much of this leverage is concentrated in conventional ‘safe’ asset markets, like government bonds, rather than traditionally in the speculative ones.” – CrossBorder Capital
Illiquidity leads to volatility, which leads to even less liquidity and more volatility. This is a real risk and has the potential to break the Fed’s hawkish spirit. If this were to materialize, the infamous “Fed pivot” would not be caused by a victory over inflation, but rather because policymakers have no choice but to step in and provide liquidity as the backstop-of-last-resort. The consequences of sitting on the sidelines would be too dire at that point.
In our view, this has become a higher probability scenario as we move into 2023. Financial stresses have largely been isolated incidents thus far, but history tells us that spillover risk and contagion can become very real, very quick.